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A U-Turn for the Money Supply?

May 05, 2002

For much of the 1970s and 1980s, it was an article of faith among many economists that increases in the money supply were a reliable predictor of increases in future economic activity. That assumption was put to the test in the 1990s, when it appeared that the link between the money supply and the real economy was becoming more tenuous.

Now, in the ultimate monetary perversion, some economists believe a declining money supply may be good news for the U.S. economy. The supply of M2--checking and savings accounts, small CDs, and money-market funds--has fallen by about $16 billion since mid-March, according to Federal Reserve data (chart). In the past, that may have been seen as a sign of economic weakness, since less need for cash would suggest that individuals and businesses aren't doing as many transactions.

This time around, the decline in the money supply may mainly reflect the increased bullishness of investors. What's happening is that they are shifting from cash and money-market funds, which are part of M2, into longer-term investments, such as bond funds, which are not. "The money supply shrinks, but it's not a sign of weakness," observes Ethan Harris, chief U.S. economist at Lehman Brothers Inc. "It's a sign of confidence."

Similarly, the strong growth in the money supply in 2001 may have partly reflected the weakness last year in the economy and stock market. During all of 2001, the money supply, as measured by M2, jumped 10.4% as investors pulled money out of the stock market, says John Youngdahl, a vice-president and senior economist at Goldman, Sachs & Co. Observes Harris: "When people are nervous about the economy, they pile into the safest investment--cash."

Is there any way to turn the money supply back into a reliable economic indicator again? Youngdahl points out that a big part of the movement in the money supply over the past six years has come from shifts in money-market funds. That's where investors tend to park cash when they are afraid to take a chance on the bond or stock markets. Hence, a more reliable measure of the money supply might be M2 minus the amount of money in money-market funds. Toting it up that way, the money supply has grown slightly in the past two months--just as traditionalists would say it should have going into an economic recovery.

Still, innovation by Wall Street firms is changing the nature of the financial system so quickly that even a monetary indicator that works today may fail tomorrow. It may just be time to let the money supply quietly retire as an economic forecasting tool. A report released by the Bureau of Economic Analysis on Apr. 23 suggests that personal income--and the economy--were weaker in 2001 than previously thought. Based on newly available data on wages, salaries, bonuses, and other payments to labor, the new figures chop about $90 billion, or about 1%, off personal income.

These revised figures bolster the case that last year's slowdown really does deserve to be called a recession. The original numbers showed that personal income, adjusted for inflation, rose by a decent 1% from the first quarter of 2001--when the downturn officially started--to the end of the year.

But according to the new data, real personal income rose by only 0.1% over that period. That's still relatively mild compared with the 1990-91 recession, but it's consistent with the distress that many Americans felt last year.

Where were the downward revisions the biggest? California was the hardest hit in percentage terms, with third-quarter personal income reduced by 2.5% below the previous estimate. Close behind were other tech-heavy states, such as North Carolina, Virginia, and Massachusetts--a sign that the original numbers had underestimated the impact of the tech bust. Germany's banks are lending less and less money to industry, threatening the country's nascent recovery. Credit growth to the private sector has slowed dramatically over the past two years, from an annualized rate of 6% in the first quarter of 2000 to 0.3% in the first three months of this year.

In part, banks are pulling back because of a surge in German corporate bankruptcies. According to Creditreform, which collects data about corporate failures in Germany, insolvencies will rise by 24% this year, to 40,000. That includes huge outfits such as construction company Philipp Holzmann, aircraft manufacturer Fairchild Dornier, and media conglomerate Kirch. The latter alone is estimated to have debts of at least $5.5 billion, of which $3.8 billion is owed to six large banks. "Banks are reluctant to lend in this environment," says Thomas Mayer, director of euro-zone economic research at Goldman Sachs & Co. in Frankfurt.

Banks' willingness to lend has also been hurt by rising concerns about profitability. Shareholders are demanding a better return on equity than what the sector has been averaging. So banks can no longer afford to lend as cheaply as they once did--but they can't raise rates because competition is so tough. Their answer is to move out of lending and into fee-based capital market products, such as equity underwriting.

So increasingly, many borrowers--especially the midsize Mittelstand companies that are the backbone of the economy--can't get the financing they need to grow. And that, say economists, means German growth will be slower than originally forecast.